Investing Basics



Investing Basics

Stocks

What Is a Stock?

Want to own part of a business without having to show up at its office every day? Or ever? Stock is the vehicle of choice for those who do. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor becomes a part owner of the company. That ownership is represented by stock -- specialized financial "securities," or financial instruments -- that are "secured" by a claim on the assets and profits of a company.

Types of Stock

Common Stock. Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it; there are absolutely no restrictions on who can purchase it. Young, old, savvy, reckless -- heck, even professional mimes are allowed to own stock. [Editor's note: Complaints about this gratuitous and completely unnecessary shot at the fine profession of mime should be directed to the Association of Professional Mimes or, if you're really feeling ornery, the White House.] Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company -- a stake in a real, living, breathing business. By owning stock -- the most amazing wealth-creation vehicle ever conceived (except for inheriting money from a relative you've never heard of) -- you are a part owner of a business.

Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.

Because they own a part of the business, shareholders get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board wields a lot of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management -- who the board hires and fires -- will give some advice, but in the end the board makes the final decision.

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value -- or even end up being worthless if the company goes bankrupt. You will learn about selecting stocks -- or businesses -- in Step 6. Analyzing Stocks.

Different Classes of Stock. Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has 10 votes per share of stock and sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.

When there is more than one kind of stock, they are often designated as Class A or Class B shares. On our Quotes & Data page, this is signified on the New York Stock Exchange and American Stock Exchange by a period and then a letter following the ticker symbol, a shorthand name for the company's shares that brokerages use to facilitate transactions. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Bel Fuse trades under the tickers BELFA (the Class A shares) and BELFB (the Class B shares).

Other Types of Stock. You will learn about preferred stock and Real Estate Investment Trusts (REITs) in Step 5. Bonds.

How Stocks Trade

Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing.

Listed Exchange. The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX, composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both "listed" exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. Volume, or the number of shares that trade on a given day, is counted by the specialist and reported to the exchange along with information on the price and size of each trade.

NYSE trades still take place face-to-face in the trading pit (yes, just like in the movies) where buyers and sellers physically converge on the specialist who matches buyers with sellers, but computers play a big part in the process these days. All trades are "auctions." There is no set price, although the last trade is often considered to be the "price" of a stock. In reality, the price is the highest amount any buyer is willing to pay at any given moment. When demand for a certain stock is high, the various buyers bid the price higher to induce sellers to sell. When demand for a stock is low, sellers must sell at lower prices to attract buyers and the price drops.

Over-the-Counter Market. The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as "market makers" for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq.

Market makers may match up buyers and sellers directly, but mostly they maintain an inventory of shares to meet the demands of the market. So when you want to sell 100 shares of ABC stock, you don't have to wait for someone else to place an order to buy 100 shares of ABC; the market maker steps in, buys them from you immediately, then sells them when a buyer comes along. Market makers and specialists keep the markets "liquid" each in their own way. You are assured that, except in extraordinary circumstances, you can always buy or sell your shares if the market is open.

"Volume" numbers under the Nasdaq system are often inaccurate. Since most trades are in and out of the market makers accounts, what would be one trade on the NYSE (where buyers and sellers are matched directly) is usually two trades on the Nasdaq.

Bid, Ask, Spread

Handling all those orders is very valuable service, and market makers (and specialists) are appropriately rewarded. Suppose you want to sell ABC and the last trade was at $6.25. When your "market" order (an order to sell at the going price) goes out on the Nasdaq system, the companies that make a market in ABC will bid for the right to buy your shares. If they see a lot of orders for ABC, they might bid $6.50 for your shares, because they know that they can turn around and ask $6.60 to sell them. If they see a slackening of demand for ABC, they might only bid $6.00 and ask $6.10. On the NYSE, specialists won't match orders for the exact same price. They will match buy orders for slightly more than the seller is asking.

The difference between the bid and ask price is the spread and it goes into the pockets of the market makers and specialists. The amount of spread will vary depending on the volume of shares traded. For a very heavily traded stocks, market makers will compete vigorously for the business and the spread will be quite small. For thinly traded stock, market makers may demand a very large spread because they may have to hold the stock for a long time before a buyer comes along, increasing the risk that they won't be able to sell it for as much as they paid.

Investors can set their own bid or ask prices, too, by placing orders to sell or buy only at a specific price. Market makers and specialists keep a close eye on these "open" orders, executing them when conditions are met, and using them to gauge demand for the stock.

Stock Derivatives: Options and Futures

Arguably the most volatile and risky investments possible, options and futures are "derivative" securities, meaning their value is "derived" from that of another security or commodity. Options and futures are both very volatile because they often carry an incredible amount of leverage. For instance, each option contract on an individual stock controls 100 shares of that stock for a fraction of the stock's current value. Since option traders have only invested a small percentage of the stock's price, any move in the price represents a big percentage change for their investment. Say they paid $5 per share for an option on a stock that sells for around $50 a share. If the price of the stock goes up $5, that's a 10% move in the price of the stock, but it's 100% of the option trader's investment. So a relatively small upward movement in the stock can be a huge upward movement for the option.

This potential for gain is offset by the fact that the entire purchase price of an option is at risk. If an investor holds an option and the underlying stock does not exceed the target price within the given time period, the option expires worthless and the entire purchase price is lost. (Most options end up worthless on their expiration date.) Traders also have to cover the price of the option. That five-dollar increase in the value of the stock wouldn't actually make the trader any money if the option expires at that point. It would just have covered the cost of the option. And if you think this is getting complicated, we've barely scratched the surface!

The Motley Fool does not consider options and futures to be worthwhile investments. Some people make a living trading derivatives -- they make their living trading against people like you. The chance of losing money with derivatives is much too high for options to be considered a useful part of any completely nutritious investment strategy.

Buying Stocks

Use a Brokerage. The most common way to buy stocks is to use a brokerage. You can either use one of the many way-too-expensive full-service (or full-price) brokers, or use a discount broker to execute your trades. You will learn more about the ins and outs of brokerages and how to pick one in our Pick a Broker section. If you're really rarin' to get started, head straight to our discount brokerage area where you can compare brokers and open an account. When you use a brokerage, you can have a cash account or a margin account ("Danger, Will Robinson. Danger!"), meaning you can borrow money to buy stocks. (Note: IRAs and custodial accounts are not allowed to be margin accounts.)

Using margin gives you more "buying power" and can increase your returns -- and your risk. Don't get carried away by the term "buying power." A better name would be "borrowing power" because that's what you are doing, and you shouldn't forget it. But brokers have a vested interest in encouraging their investors to use margin, so they like the sexy name. Brokers make a good part of their money from margin loans, plus buying on margin generates more commissions. Margin loans are a great racket. The broker collects the interest and has total control over the collateral for the loan, including the ability to step in and force you to sell stock if they think you are in danger of defaulting on their loan. Margin is a two-edged sword for investors -- but it's a cash cow for brokers. For more details on margin, check out this Margin Foolnote.

Dividend Reinvestment Plans (DRPs) and Direct Investment Plans (DIPs). Known lovingly by many investors as Drips, these are plans sponsored by individual companies that allow shareholders to purchase stock directly from a company with only minimal costs or commissions. These plans are great for those who have small amounts of money but who are willing to invest it at regular intervals. You will learn more about DRPs and DIPs in the Motley Fool's comprehensive Drip Area, which is more exciting than it sounds!

Shorting Stocks

If you buy a security with the expectation that the price will rise, you are "long" the stock. But you can profit from stocks that go down, too. This is an advanced investing technique called "short selling." When you short a stock, your broker arranges for you to borrow stock from a pool of shares maintained by brokers for that purpose. The shares are then sold and the proceeds from the sale are credited to your brokerage account.

At some point in the future, you must "close" the short by buying the same number of shares (adjusted for any splits that might have occurred) in the market and returning them to the short pool. If the price of the stock has gone down while you were holding it, you can use the money you received from the sale of the borrowed shares to buy the stock, and you will have cash left over. That's how you profit from a stock that goes down. Unfortunately, if the stock has gone up, you will have to add some money of your own when closing out a short position. That's how you lose money when a stock goes up.

Properly done, shorting can work as a hedge against a falling market. Improperly done, you can lose even more money on a short than you would lose if you invested in a company that went bankrupt. Imagine that you buy a company for $50 per share and it goes belly up. You've lost $50. (You should have shorted it!) But imagine shorting a stock for $50 that subsequently triples. When you close that short position, it will cost you $150 a share to buy back the shares you sold for $50. Many a short seller has been caught in this trap because brokers won't let you hold on to a short position unless you have money or other assets to cover the short at all times.

The basics of the shorting transaction are straightforward. Most online brokerages have a box to check for a short sale or a "buy to cover." Occasionally there won't be enough shares in the short pool and a short sale won't go through. There are also rules about shorting stocks that are dropping fast, so you can't always assume a short sale will be as smooth as a straightforward purchase, but in most cases it is. For more information on shorting, check out the Shorting Foolnote.

Summary and Next Steps

We hope that this hasn't been the most painful thing you've had to read this week. You're now conversant enough in stock market matters to impress those who are very easily impressed. You've learned that each share of stock represents a proportional share of a business and that the potential rewards are great but that stocks are also riskier than putting money in the bank. You're also aware of the different types of stock (and how each classification is reflected in the ticker symbol), how they are traded on the exchanges, and how to buy them. You even learned a little about options and shorting stocks.

A word of caution at this point: Knowing the terms and general workings of the stock market is just the first step in your investing career. We think that only fools (note the lowercase "f") would jump in and start shorting stocks or considering options at this point. Later on in Investing Basics we'll get back to individual stocks as we explore investing approaches in Step 6. But now onto Step 4. Mutual Funds - many of which are invested in the stocks we have discussed here.

Margin Foolnote

Cash vs. Margin. If you invest in stocks just with the money you have in your brokerage account, you are using a cash account. If you borrow money from the brokerage to invest in stocks, you are using a margin account. If you borrow money in a margin account to buy stocks, keep in mind that this is not at all "free" money. Your collateral for borrowing the money is the marginable securities in your account, which means they are forfeit if you cannot otherwise repay the margin loan. You also have to pay a fixed amount of interest on the borrowed money on a monthly basis, which can reduce your overall returns. Because IRAs and other retirement accounts are cash accounts, you cannot use margin in them.

Why Use Margin? Many investors use margin to "juice" up their returns, but fail to appreciate that it can also "squeeze" down their returns. Just as you can make more money than you otherwise would have by using margin, using margin inherently puts you in the Double Jeopardy round - where your running tally can either move up or move down much more quickly than without margin. The worst-case scenario is when a stock price drops so much that it causes a "margin call," which means you either add more money to the account or you automatically get sold out of the position at a loss.

What Stocks Are Marginable? The Federal Reserve Board currently regulates which stocks are marginable. As a general rule, stocks selling below $5 are never marginable and recent initial public offerings are rarely marginable, although it does happen on occasion. Beyond this, individual brokerages also can decide not to margin certain securities for various reasons. Because of this, your brokerage is always the best source of information for finding out whether or not a security is marginable.

Initial and Maintenance Margin Requirements. The amount you can borrow on margin is limited by both the Federal Reserve Board and the individual brokerage you use. There are two requirements - how much margin you can initially use and then how much margin you can have after you make the initial transaction. Although each brokerage is different, as a general rule 50% of the purchase price of any security can be margin. After you take the position, there is a maintenance margin account requirement that is normally much lower, often around 25%. Check with your brokerage to find out your initial and maintenance margin requirements.

Calculating Buying Power. After you find out the margin requirements at your brokerage, you can calculate your buying power. This is how much total stock you can buy given your current cash and marginable securities, including margin. For instance, if you have $3000 in cash or marginable securities and the initial margin requirement is 50%, you have $6000 in initial buying power ($3000 equity/($3000 equity + $3000 margin) = $3000/$6000 = 50%). Be very careful when calculating how much buying power you have in your account, as nonmarginable securities do not contribute at all to your buying power.

Margin Call. Should you fall below the margin requirements, you may be subject to a margin call. If so, you have three days to send in more cash or securities to cover the deficiency or you will be forced to sell out of your positions. How can you calculate how close you are to the requirement? If you took the $6000 position described above using $3000 in margin and your maintenance margin requirement was 25%, the position could fall as low as a total value of $4000 before you risked a margin call. ($1000 equity/($1000 equity + $3000 margin) = $1000/$4000 = 25%).

Using Margin. Just as the Fool eschews credit-card debt, we do not believe that the average investor should or needs to be using margin. Although very aggressive, experienced investors could probably margin their accounts up to 20% without incurring a margin call, the fact that your losses are exacerbated should give even the most fearless investor pause. However, because most brokerages will let you short stocks only if you have a margin account - even if you have the cash to cover the short in your account - you may, nonetheless, end up signing that margin agreement and sending it off to the brokerage. Once this is done, however, don't be in any rush to give that margin a test spin: The Fool doesn't let new Fools use margin.

Shorting Foolnote

What Is Shorting? An investor who sells stock short borrows shares from a brokerage house and then sells them to another buyer. Proceeds from the sale go into the short-seller's account. He must eventually buy those shares back (called covering) at some point and return them to the lender. The short-seller expects that the stock price will go down, so when he buys back the stock to cover, he will pay less for the shares and keep the difference.

Thus, if you sell short 1000 shares of Gardner's Gondolas at $20 a share, your account gets credited with $20,000. If the boats start sinking - since David Gardner, founder and CEO of the company, knows more about singing gondolier show tunes than about keeping gondolas afloat - and the stock follows suit, tumbling to new lows, then you will start thinking about "covering" your short there for a very nice profit. Here's the record of transactions if the stock falls to $8:

|Borrowed and sold short 1000 shares at $20: |+$20,000 |

|Bought back and returned 1000 shares at $8: |-$8000 |

|Profit |+$12,000 |

But what happens if as the stock is falling, Tom Gardner, boatsman extraordinaire, takes over the company at his brother's behest, and the holes and leaks are covered? As the stock begins to take off, from $14 to $19 to $26 to $37, you finally decide that you'd better swallow hard and close out the transaction. You do so, buying back shares at $37 each.

Here's the record of transaction:

|Borrowed and sold short 1000 shares at $20: |+$20,000 |

|Bought back and returned 1000 shares at $37: |-$37,000 |

|Loss |-$17,000 |

Ouch. So you see, in the second scenario, you lost $17,000 ... which you'll have to come up with. There's the danger of shorting - you have to be able to buy back the shares you initially borrowed and sold. Whether the price is higher or lower, you're going to need to buy back the shares at some point.

Covering and Called Away. When you buy back the shares you have borrowed and return them, this is called covering your short. Although most of the time you can hold a short indefinitely, there are two situations in which you can be forced to cover. The first is when you get a margin call because you have hit your margin maintenance level (described in the Margin Foolnote. Unless you put more money in the account within three days, you will be forced to cover.

The second circumstance is when you have your short "called away." You can actually be forced to cover if the shareholders you have borrowed from sell their positions. As they cannot sell what they do not have, your brokerage either has to come up with new shares for you to borrow or you have to cover. This is rare, but it occurs occasionally when a lot of one particular stock is sold short.

You Can Lose More Than You Have. The most important thing to recognize when shorting is that you can lose more money than you initially invested in the short. Your downside is limited only by the fact that you will eventually get a margin call when your account reaches its margin maintenance level. The best you can hope for in a short sale is for a company to go out of business and stop trading, which means you never have to cover and you score a 100% gain.

Short Interest. Many investors often want to know how much of a particular stock is sold short before they will short it themselves. Two ways to assess this are short interest and days to cover. Short interest is the total number of shares that have been sold short. Many investors will take this number and compare it to the total number of shares outstanding, or the "float" (shares available for trading by the public), in order to get a sense of the%age of stock that has been sold short. Many times, when a high%age of the float has been sold short, it becomes difficult to initiate new short positions. If too much of the stock is held short, it can lead to a short squeeze (see below).

Days to Cover. Days to cover, also known as the short interest ratio, takes the number of shares sold short and divides this by the average daily volume in the stock to show how many days' average volume it would take to cover all of the shorts. For instance, if there are 1,000,000 shares sold short and the average daily volume is 10,000 shares, there are 100 days to cover (1,000,000/10,000 = 100 days). The reason many people pay attention to this is the belief that if a company has been shorted by a lot of people, it is actually a positive indicator because all those shorts have to buy back shares at some point. Academic studies have failed to support this notion, however, consistently showing that highly shorted stocks tend to underperform the indexes by a large margin.

Short Squeezes. When a number of short sellers all try to cover their short positions at the same time, it can drive the stock price up very quickly. This is called a short squeeze, as the upward movement of the price actually induces more short-sellers to cover, pushing the stock price even higher. Although most of the time news will start a short squeeze, occasionally traders who see a company with a high number of days to cover will start buying the stock to set off a short squeeze. For this reason, we advise that you avoid shorting stocks that already have a fairly hefty amount of existing short sales.

Dividends and Stock Splits. If a stock pays a dividend while you are selling it short, you actually have to pay the dividend. Because you borrowed the shares and sold them, the company does not have to pay a dividend to you as you do not own any shares. However, the person you borrowed the shares from expects a dividend and you have to ante up. If a stock splits 2-for-1 while you are selling it short, you owe twice the amount of shares back (although presumably at half the price).

Why Short? Since you are betting that the stock price will go down when you short a stock, many people believe that shorting is un-American. However, you shouldn't totally rule out selling short - for long periods of time, like the 1930s and the mid-1970s, almost the only way an investor could have made money in the stock market was by short selling. The long and the short of it is that those who oppose shorting don't recognize that every transaction requires a buyer and a seller. Because it provides a ready supply of sellers, short selling helps maintain a liquid and rational market.

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